Q&A With David Rosenberg: The Bearish Outlook
Courtesy of Tyler Durden at Zero Hedge
The WSJ’s Greg Zuckerman has published a Q&A with one of the world’s biggest deflationists (who nonetheless admits that once QE 2 begins all bets are off): David Rosenberg. Here is how Rosie sees the world of finance over next 2 years, provding more color on his currently favorite investment strategy (aside from bonds): SIRP (Safety and Income at a Reasonable Price… and in keeping with acronyms RIP GARP).
Where is the market headed the rest of this year and over the next 12-18 months?
The market, like life and the seasons, moves in cycles — 16 to 18 year cycles, in fact. Sadly, this secular down-phase in the equity market began in 2000 when the major averages hit their peak in real terms, and so the best we can say is that we are probably 60% of the way into it. This by no means suggests that we cannot get periodic rallies along the way, but in a secular bear market, these rallies are to be rented, not owned.
In contrast, corrections in a secular bull market, as we saw in 1987 (as scary as it was) are opportunities to build long-term positions at more attractive pricing. In secular bear markets, the indices do hit new lows during the recessions (ie, 2002, 2009), when they occur; in secular bull markets, you do not make new lows — they are just corrections (ie, 1987, 1990, 1994, 1998).
The market is not as cheap as the pundits, who rely on year-ahead EPS estimates, deem it to be. When one incorporates cyclically-adjusted corporate earnings in ‘real’ terms, equities are still roughly 20% overvalued even after the recent correction.
More fundamentally, it would seem reasonable to expect that the equity market will trade down to a valuation level that is historically commensurate with the end of secular bear markets. This would typically mean no higher than a price-earnings multiple of 10x and at least a 5% dividend yield on the S&P 500. So, we very likely have quite a long way to go on the downside.
But it will not be a straight line and there will be intermittent rallies, as we experienced a year ago April; however, not even that 80% bounce off the lows managed to violate any of the long-term trend lines, which continue to portray a primary bear market, not unlike what we endured from 1966 to 1982. Back then the principal cause was an inflationary spiral; this time it is a deflationary debt deleveraging that is the root cause. Within the next 12 to 18 months, I can see the S&P 500 breaking back below 900, and a substantial test of the March 2009 lows cannot be ruled out.
What about the outlook for the U.S. and global economy?
I strongly believe that the economic recovery phase is behind us. Even if we manage to avert a double-dip recession, the chances of a growth relapse in the second half of the year are higher than the equity market and, to a lesser extent, the credit markets have priced in. Treasuries seem to be the asset class that most closely shares my cautious views. Anyone with a pro-cyclical bent has to answer for why it is that the yield at mid-point on the coupon curve is below 2%, a year after a whippy rally in equities and commodities and what appeared to be a sizeable policy-induced GDP jump off the bottom.
Given the unprecedented massive government intervention across the planet, it can hardly come as a surprise that economic activity began to recover exactly a year ago. But when the equity market was hitting its recovery highs in early spring, it reflected a widespread view that the green shoots of 2009 would be extended into a sustainable growth phase into the future. Not a good assumption then; and not one now.
All of the optimism that dominated the marketplace over the past year overlooked a significant fact. While U.S. banks have recapitalized themselves and written off debt, this cycle has been dominated by governments socializing the losses and taking the bad debts from the private sector and transferring the liabilities to the public sector balance sheet. The debt problem was merely shifted from the private sector to the government sector.
The Greek sovereign debt crisis has acted as the proverbial canary in the coal mine, underscoring the view that governments have probed the outer limits of their deficit financing capabilities. This has important implications for the economic outlook since the recovery has really been one part bailout stimulus, to one part fiscal stimulus, to one part monetary stimulus, to one part inventory renewal. Now that the boost to growth from the inventory bounce has run its course, the stimulative effects of fiscal policy will diminish in coming quarters as the public backlash against further increases in the debt-to-income ratio constrains the government’s ability to continue to try and fine-tune the economy.
The dramatic government incursion into the macro landscape and capital markets obscured the fact that the economy is still in the throes of a multi-year credit contraction phase and as such what we can expect is for the pace of activity to weaken substantially during the periods when the stimulus fades. This is what we can expect in the second half of the year and into 2011 when tax rates rise substantially for many Americans.
Even if we don’t get a double-dip recession, and I think at a minimum what we’re going to get is a 2002 style growth relapse when GDP growth converges on final sales somewhere around a 1% rate; the consensus right now is for a 3% second half growth, which is right where it was heading into the second half of 2002.
The difference of course is back then the Fed had had room to cut rates 75 basis points, President Bush had the fiscal flexibility to cut taxes dramatically and we went and started a war, which is always reflationary. We don’t have these outlets today.
outlook, the bloom is off the rose as well. The OECD leading indicator in May turned in its softest pace since the depths of despair in March 2009. China’s massive stimulus program has run out of steam and the government has been tightening policy this year to redress substantial over-investment in real estate and what may well be an unsustainable price bubble. At the very least, China is unlikely to be the engine of global growth to as great an extent as it has been. Much of Europe is in massive fiscal retrenchment mode, and the peaking out in commodity prices will also have dampening effects on the resource-producing countries, particularly in the once-hot Latin American economies.
What keeps you up at night and what worries you most about the investing environment?
Bad government short-term decisions over good long-term solutions are burying the world into a graveyard of debt. People have to understand that 80% or higher debt-to-GDP ratios are a new dynamic and a game changer in Europe and in the United States. The bottom line is that all levels of society, and across most countries in the industrialized world, have far too much debt and far too much debt-servicing costs in relation to income.
For the entire OECD countries, general government debt as a share of GDP alone has ballooned from 73% when the recession started in 2007 and will climb to a record 104% next year. It took 15 years for this ratio to go from 63% to 73% and just four years from 73% to 103%. Total claims in the OECD at all levels of society just broke above 360% of GDP and that is clearly unstable. Suffice it to say, many of these debts will not be serviceable — identifying where the defaults and haircuts take place, across countries and sectors, will require a tremendous level of skill.
The problem of excessive debt leverage got worse in the aftermath of the financial crisis, not better. This is what keeps me up at night — kicking the can down the road in terms of addressing the global debt problem will only end up making the situation worse. Governments seem to believe that the solution to a debt deleveraging cycle is to create even more debt. But delaying the inevitable process of mean-reverting debt and debt-service ratios back to historical norms will be even more painful.
There is simply no quick fix to resolve the massive global imbalances that were allowed to build during the prior credit bubble. Yet, governments continue to adopt policies that do not address problems that are highly structural in nature and will require years of fiscal belt-tightening on the parts of consumers in much of the industrialized world, and in the public sector as well.
What makes you most enthused about the investing environment?
We are entering into a period of stable consumer prices that should last at least for a generation. This will help prevent erosion in real household incomes. There is a strong probability that after years of very solid productivity gains in the industrial sector, the U.S. will experience a manufacturing renaissance of sorts and re-emerge as a global export leader. The move towards frugality and savings will make us less reliant on foreign borrowings and usher in a period of stronger household balance sheets.
Where are you investing right now? Where do you plan to invest in 2011? What should investors do with their portfolios?
My primary strategy theme has been S.I.R.P. (Safety and Income at a Reasonable Price) because yield works in a deleveraging deflationary cycle. Not only is there substantial excess capacity in the global economy, primarily in the U.S. where the “output gap” is close to 6%, the more crucial story is the length of time it will take to absorb the excess capacity. It could easily take five years or longer, depending of course on how far down potential GDP growth goes in the intermediate term given reduced labour mobility, lack of capital deepening and higher future tax rates. This is important because what it means is that disinflationary, even deflationary, pressures will be dominant over the next several years.
Moreover, with the median age of the boomer population turning 55 in the U.S., there is a very strong demographic demand for income and with bonds comprising just 6% of the household asset mix, this appetite for yield will very likely expand even further in coming years. Within the equity market, this implies a focus on squeezing as much income out of the portfolio as possible, so a reliance on reliable dividend yield and dividend growth makes perfect sense.
We are in a period of heightened financial market volatility, which is typical of a post-bubble deleveraging period when the forces of debt deflation are countered by massive doses of government reflationary polices. This to-and-fro is the reason why in the span of a decade we have seen two parabolic peaks in the equity market (September 2000 and October 2007) and two depressed bottoms (October 2002 and March 2009). As I have said before, 80% rallies in a 12-month span, as we saw in the year to April, last happened in the early ‘30s and were followed by gut-wrenching spasms to the downside. So for any investor, return of capital is yet again reemerging as a very important theme, and the need to focus on risk-adjusted returns. This, in turn, means a strategy that minimizes both the volatility of the portfolio and the correlation with the equity market is completely appropriate — the best way to play this is with true long-short hedge fund strategies.
Gold is also a hedge against financial instability and when the world is awash with over $200 trillion of household, corporate and government liabilities, deflation works against debt servicing capabilities and calls into question the integrity of the global financial system. This is why gold has so much allure today. It is a reflection of investor concern over the monetary stability, and Ben Bernanke and other central bankers only have to step on the printing presses whereas gold miners have to drill over two miles into the ground (gold production is lower today than it was a decade ago; hardly the same can be said for fiat currency).
Moreover, gold makes up a mere 0.05% share of global household net worth, so small incremental allocations into bullion or gold-type investments can exert a dramatic impact. Gold cannot be printed by central banks and is a monetary metal that is no government’s liability. It is malleable and its supply curve is inelastic over the intermediate term. And central banks, who were selling during the higher interest rate times of the 1980s and 1990s, are now reallocating their FX reserves towards gold, especially in Asia.
